Opportunity Cost

Introduction

Opportunity cost refers to what you have to give up to buy what you want in terms of other goods or services. When economists use the word “cost,” we usually mean opportunity cost.

The word “cost” is commonly used in daily speech or in the news. For example, “cost” may refer to many possible ways of evaluating the costs of buying something or using a service. Friends or newscasters often say “It cost me $150 to buy the iPhone I wanted.”

Definitions and Basics

When economists refer to the “opportunity cost” of a resource, they mean the value of the next-highest-valued alternative use of that resource. If, for example, you spend time and money going to a movie, you cannot spend that time at home reading a book, and you can’t spend the money on something else. If your next-best alternative to seeing the movie is reading the book, then the opportunity cost of seeing the movie is the money spent plus the pleasure you forgo by not reading the book….

To get the most out of life, to think like an economist, you have to be know what you’re giving up in order to get something else….

Sometimes people are very happy holding on to the naive view that something is free. We like the idea of a bargain. We don’t want to hear about the hidden or non-obvious costs. Thinking about foregone opportunities, the choices we didn’t make, can lead to regret. Choosing this college means you can’t go to that one. Marrying this person means not marrying that one. Choosing this desert (usually) means missing out on that one….

Economics has been called the dismal science because it studies the most fundamental of all problems, scarcity. Because of scarcity we all face the dismal reality that there are limits to what we can do. No matter how productive we become, we can never accomplish and enjoy as much as we would like. The only thing we can do without limit is desire more. Because of scarcity, every time we do one thing we necessarily have to forgo doing something else desirable. So there is an opportunity cost to everything we do, and that cost is expressed in terms of the most valuable alternative that is sacrificed….

In the News and Examples

Opportunity cost, rock concerts, and grades: A Fable of the OC, by Mike Munger on Econlib.

You get to the box office about midnight, but don’t sleep much because it’s noisy. Finally, sleep does come. It only seems like a few minutes later when the clank of the ticket window opening wakes you at 8:00 am. In the sunlight, you notice that there are way more people in line than you thought. Thousands, in fact. You may not get tickets, even after camping out… But you start thinking about opportunity cost, the big OC. You recall from economics class that the OC is about foregone alternatives. In other words, the cost of doing one thing is all the other things you don’t get to do as a result…. I used this fable (sort of—it was Bruce Springsteen then) as a test question in my intermediate Microeconomics class at Dartmouth College….

Biggest cost of college is what students could otherwise earn by working. See Human Capital

Tuition and fees are not, for most college students, the major cost of going to college. On average, three-fourths of the private cost of a college education–the cost borne by the student and the student’s family–is the income that college students give up by not working. A good measure of this “opportunity cost” is the income that a newly minted high school graduate could earn by working full-time. During the 1980s and 1990s, this forgone income rose only about 4 percent in real terms. Therefore, even a 67 percent increase in real tuition costs in twenty years translated into an increase of just 20 percent in the average student’s total cost of a college education.

“Economics is the study of how to get the most out of life.” Tyler Cowen, of George Mason University, talks about his new book, Discover Your Inner Economist: Use Incentives to Fall in Love, Survive Your Next Meeting, and Motivate Your Dentist. Cowen, legendary blogger at MarginalRevolution.com, talks with EconTalk host Russ Roberts about the economics of parenting, reading, dentistry, art museums and education. Highlights include Tyler’s favorite art museum and what to see there along with the challenges of being a tourist in Morocco….

Opportunity cost and TANSTAAFL:

Chris Anderson on Free. EconTalk podcast episode, May 12, 2008. Specifically, explanation of the economic meaning of “There ain’t no such thing as a free lunch,” starting at time mark 47:11.:

Chris Anderson talks with EconTalk host Russ Roberts about his next book project based on the idea that many delightful things in the world are increasingly free–internet-based email with infinite storage, on-line encyclopedias and even podcasts, to name just a few. Why is this trend happening? Is it restricted to the internet? Is there really any such thing as a free lunch? Is free a penny cheaper than a penny or a lot cheaper than that? The conversation also covers whether economics has anything to say about free….

While shopping for my first stereo, I spent an hour debating between a $1,000 Pioneer and a $700 Sony. Perhaps fearing that my indecision would cost him a sale, the salesman intervened with the comment “Well, think of it this way–would you rather have the Pioneer, or the Sony and $300 worth of CDs?”

“Jane Galt” describes an article by Jamie Galbraith that, among other things, adds together the Budget cost of the war and the “opportunity cost” of doing something else, such as expanding health care spending. This is double-counting. The Budget cost is the opportunity cost….

Opportunity cost and crowding out of public projects. Public funding of public works projects is at the expense of other alternative, forgone, and equally worthy projects and goals. See:

Projects involving major expenditure and intended to produce future benefit are usually assessed in terms of expected payback. Comparing expected yield to the interest rate, or discounted cash flow to the capital cost of the project, are the standard ways of judging whether it is worth while. In an accounting sense, the cost is straightforward. It is seen as and when it is incurred. “What is the cost of a million-dollar project?” is a silly question. The answer is in the question: it is a million dollars….

Hidden Inventions: A persistent claim is that in market economies where the profit motive reigns supreme, extremely valuable inventions are hidden to prevent their sale. Supposedly, if the inventions were available they would destroy the profits of big corporations by making their products obsolete. So these corporations buy up wonderful inventions to make sure we can’t buy them.

That an amazing invention has never been found in some secret warehouse does nothing to reduce people’s belief that such things exist; they’re hidden, aren’t they? The reality is that the opportunity cost of hiding a valuable invention is so great that inventions worth more than they cost are quickly made available. Hidden inventions exist only in economically uninformed imaginations….

Michael Munger of Duke University and host Russ Roberts talk about the economics of ticket scalping, examining our reactions to free and found goods, gifts, e-Bay, value in use vs. value in exchange, and opportunity costs.

A Little History: Primary Sources and References

In spite, therefore, of the purely relative character of pain and pleasure and of the essential parity as motives of all alternatives of conduct, it is pragmatically necessary to distinguish in productive activity between the incoming “economic” utility and the sacrificed (resources, representing) non-economic, unspecified alternatives in general, between utility and disutility, or commodity and cost. “Cost,” in this sense, is “pain cost,” or “opportunity cost,” as one prefers; there is no real difference in meaning between the two…. [par. II.III.33]

Advanced Resources

In full market equilibrium expected marginal benefit for each participant will be equal to marginal opportunity cost, both measured in terms of the person’s subjective valuation. All persons confront uniform relative prices for goods; this is a necessary condition for the absence of further gains-from-trade. Since each participant is in full behavioural equilibrium, it follows that each person must also confront the same marginal cost. As a demander the individual adjusts his purchases to insure that marginal benefit equals price. Hence the anticipated marginal benefits of a good, again measured in the numeraire, are equal for all demanders. As a supplier the individual adjusts his sales to insure that anticipated opportunities forgone, marginal opportunity cost, equals price. Hence marginal opportunity cost in the numeraire is equal for all suppliers….